Financial Reporting – Financial Statement Analysis

Financial Statement Analysis

Who is interested in analysing a financial statement?

• Owners
• Customers
• Competitors
• Students who didn’t realise that they had signed up for CSwBM and wanted to do CS
• Competitors
• Employees, unions
• Government
• Community representatives
• Investment analysis
• Suppliers
• Lenders
• Managers

Basically lots of people.

Examples

• Shareholder wants to see whether to keep their investment in the company
• Long term lenders want to see if the company will make their scheduled payments
• Short term lenders want to see if the short term debts will get paid off

Financial Ratios

They are a quick way of assessing the financial health of a business, and when comparing two businesses they eliminate differences in scale.

Some ratios:

• Profitability: Give insight into how successful the business is at creating profit
• Efficiency: How efficient the business is at using resources
• Liquidity: Ability to meet liabilities when due
• Financial Gearing: Degree of risk and how the business is funded
• Investment: Returns and performance

Examples from earlier revisited

• Shareholder wants to see whether to keep their investment in the company — Look at profitability, investment and gearing ratios
• Long term lenders want to see if the company will make their scheduled payments — Profitability and gearing ratios
• Short term lenders want to see if the short term debts will get paid off — Liquidity ratios

Profitability Ratios

Return on shareholder’s funds:

[Profit after tax ÷ (Share capital + reserves)] x 100

Compares amount of profit available to the owners with the owners investment in the business. High is good.

Return on capital employed:

[Operating profit ÷ (share capital + reserves + long term liabilities)] x 100

The relationship between OP and long term capital.

Operating profit margin:

(operating profit ÷ sales revenue) x 100

A good measure of operational performance. Can vary a lot between business types. Supermarkets have low OP margins. Jewellers have high.

Gross profit margin:

(gross profit ÷ sales revenue) x 100

This is a measure of profitability in buying and selling goods

Example

Company A has £350 revenue and £255 cost of sales. Their gross profit margin is [(350 – 255) ÷ 350] x 100 = 27%

Efficiency Ratios:

Average inventories turnover period:

(Average inventories held ÷ cost of sales) x 365

The average length of time inventories are held. Businesses prefer this to be short.

Average settlement period for trade receivables:

(Trade receivables ÷ Credit sales) x 365

How long it takes debtors to repay. Shorter is preferred.

Average settlement period for trade payables:

(Trade payables ÷ credit purchases) x 365

How long it takes the business to repay credit purchases. Try to keep it low.

Sales revenue to capital employed: (asset turnover ratio)

Sales revenue ÷ (share capital + reserves + non current liabilities)

How effectively assets are being used to generate revenues. High indicated higher productivity. Too high may be overtrading and non sustainable.

Sales revenue per employee:

Sales revenue ÷ Employees

High indicates greater staff efficiency.

Example

A company makes £475 in sales and £65 in trade receivables. What is the average settlement period for trade receivables?

(65 ÷ 475) x 365 = 50 days

Return on capital employed

Operating Profit x Sales Revenue

• Influenced by profitability and efficiency

Liquidity Ratios

Current ratio:

Current assets ÷ Current liabilities

Good to be higher than 1, as assets can cover liabilities. Manufacturing tends to have a high one, supermarkets have a low one.

Acid test ratio:

Current assets (but not inventories) ÷ Current Liabilities

Excludes inventories because they cannot be turned into cash quickly.

Cash generated from operations to maturing obligations:

Cash generated from operations ÷ Current liabilities

Indication of the ability of the business to meet obligations. High is better.

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